Banking

EMU fudges contributed to sovereign woes

WilliamL. Watts

LONDON (MarketWatch) -- Once again, financial markets are in turmoil due to fears that a profligate member of the 16-nation euro zone may be forced to default on its sovereign debt.

Greece, saddled with a massive budget deficit and record debt, saw its credit rating cut to BBB+ late Wednesday by Standard & Poor's, having seen a similar cut by Fitch Ratings just over a week ago. The nation became the first in the euro zone to be rated below single-A.

Also, Standard & Poor's put Spain, which lost its AAA rating earlier this year, on negative credit watch. Ireland also lost its AAA rating this year. See story on Europe's debt crisis.

Fears of a potential default by Greece, something economists say isn't likely to happen soon, have weighed recently on bonds issued by so-called peripheral euro-zone governments. Yield spreads between peripheral euro-zone bonds and German bonds, the region's benchmark, have widened as investors demand a higher premium to hold debt issued by the likes of Greece. See story on playing the crisis.

The euro has also seen bouts of pressure tied to the turmoil.

How did it come to this? After all, European economic and monetary union, now in its second decade, was supposed to quell turmoil and promote stability.

Part of the reason is that the mechanism for ensuring that members toed the line on budget policy has never been particularly robust. To some economists, the stability and growth pact, which was derived from the Maastricht Treaty that set the parameters for euro membership, has always been vulnerable to statistical fudges.

Under the criteria, a candidate country's deficit couldn't exceed 3% of gross domestic product, while public debt was capped at 60%. Those same criteria are at the heart of the stability and growth pact, which governs all members of the European Union.

"The Maastricht criteria were designed not because they happened to be sound, but because everyone was expected to pass them, except Italy," said Gabriel Stein, economist at Lombard Street Research.

That appeared to be by design. Germany and France were the main proponents of EMU. And the German government had promised its citizens the new euro would be comparable in strength to the inflation-averse deutschemark.

Keeping high-inflation, high-debt countries like Italy and its southern neighbors out of the euro was a priority.

But as important deadlines neared, Germany found itself struggling to meet the criteria.

In 1997, the country's finance minister, Theo Waigel, went to the Bundesbank in an effort to convince the nation's central bankers to allow an upward revaluation of its gold reserves. The resulting boost would be used to cut the deficit and the debt, ensuring Germany met the entry criteria.

The hard-line Bundesbank refused to go along, dismissing the proposal as a gimmick that would open the door to similar shenanigans by other prospective EMU members.

In the end, Germany failed to meet the debt limit, while France was left open to charges it fudged the criteria through accounting tricks. Germany's bid to keep out Italy and other southern European countries failed.

The stability and growth pact incorporated much of the Maastricht criteria. It calls on euro-zone countries to keep deficits below 3% of GDP and deficits below 60%, but allows some flexibility in tough economic times.

While the process for imposing sanctions on countries that violate the pact has been implemented against smaller countries in the past, fines have never been levied.

And critics note that big countries, such as Germany and France, have avoided the punitive process altogether when they've ran big deficits.

In effect, the pact served more as a set of guidelines than hard and fast rules, allowing governments to use shadow accounting to hide liabilities, said Lena Komileva, head of G7 market economics at Tullett Prebon.

In the end, the pact did little to help "southern Europe to consolidate its public finances as fast as the discipline imposed by EMU would warrant," she said.

In Greece's case, the newly-elected Socialist government shocked financial markets and European Union policy makers this fall. It projected the nation's deficit would top 12% of GDP, more than double a previous estimate and more than four times the 3% limit imposed by the stability and growth pact.

Last Thursday, the government admitted that its debt stood at 300 billion euros, a record for the nation. It's already vowed to trim the deficit to around 9% this year.

Thirteen E.U. countries are currently over the pact's deficit limit and have been given between two and five years to move into compliance by the European Commission.

While growing deficits would be expected in the face of a deep downturn, critics charge that tougher enforcement would have left many countries in a better fiscal position to deal with the crisis when it hit.

Lombard Street's Stein says the shortcomings of the pact are less important now than the question of how policy makers deal with the threat of default by a euro-zone member.

"Is [European economic and monetary union] purely a monetary union or is it, as it was intended to be, a political project?" he said. "Remember, the 'e' [in EMU] stands for economic as well."

Big questions surround how a default would be handled and what it would mean for the single currency. And European officials give conflicting signals on whether another element of Maastricht -- the "no bailout clause" -- will stand.

"At the moment you have this very strange attitude where (yield) spreads widen from time to time," Stein said.

"But the truth is, if you don't believe in the no-bailout clause, there should be no spreads at all" because there's no risk of default, he said. "And if you believe in it, [the spreads] should be much wider," he said.

Of course, applying tough sanctions to the region's hardest hit economies now would be counterproductive and likely to panic financial markets, Komileva said.

She expects the harsh conditions to be imposed in the wake of the crisis to do more to reform fiscal policy than the stability and growth pact or other measures anyway.

"This crisis is bound to change public sector attitudes for a generation," she said. "The reason being that we are going to feel the corrosion caused by weak economic activity and tough market conditions on the public finances well into the next decade."

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